In Praise of Balance

In late 2003, a reader wrote to me, Kiplinger's Portfolio Doctor, and bemoaned her sagging IRA. It had several stocks and a bunch of inconsistent funds. Loads and high expenses hurt, as did lousy fund management. Still, it was the sort of aggressive portfolio you might expect eventually to out-earn a simple mix of two parts staid blue-chip stocks and one part AA-rated bonds. Instead, it was an albatross.

I've received scores of similar letters. This one stands out because the writer added, "If I had invested all of my IRA money over the years in Vanguard's Wellington fund (VWELX), instead of just some of it, I'd be better off than I am today." I'm sure she's right. It's easy to admire Wellington's numbers. Over the past ten years, Wellington has returned 10% annually. That's one percentage point more than Standard & Poor's 500-stock index and better than the return on 80% of the large-growth-stock funds in Morningstar's universe, including such top-ranked funds as Brandywine (BRWIX) and Harbor Capital Appreciation (HACAX).

But Wellington isn't a growth fund. It's a balanced fund that is less volatile and normally composed of 60% stocks and 40% bonds, managed by different people. The fund has a little flexibility in the overall allocation. Today, it's at 65% stocks. Larry Swedroe, the author of several investment books that preach indexing, once told me Wellington is about the only actively managed fund he likes.

Wellington's been in the news because it's finishing stage two of a rare management change. In 2002, the stock portion got a new manager. In a few months, its longtime bond manager Paul Kaplan retires. However, the replacements are qualified and experienced. Vanguard says any changes to Wellington's strategy will be minimal, unlike, say, the dramatic shakeups Fidelity Magellan fund (FMAGX) makes whenever Fidelity changes its skipper.

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With this as background, let's discuss the very idea of a balanced fund. I like them -- at least the ones that work -- but many financial advisers and mutual fund experts think a balanced fund is a dumb idea. Incidentally, the category is now sometimes called "moderate allocation," which refers to a "moderate" 50% to 70% invested in stocks. The word "balanced" could be misinterpreted to suggest a strict 50-50 weighting of bonds and stocks, when in fact there is wiggle room.

Critics of the balanced-fund concept start by pointing to what they regard as a glaring flaw: Because it is two funds in one, you have two chances that one side or the other will be disastrous. You can't easily tell this if you just look at the total return and yield figures and rankings. But here's a clue: Find the long-term return, preferably five or ten years, of a balanced fund. Then compare its stock and bond weightings with their appropriate benchmarks. With stocks, use the SP 500. With bonds, you'll want a Treasury index, or if the fund owns corporate bonds, as Wellington does, the broader Lehman Brothers aggregate bond index.

The SP 500 has averaged a 9% return over ten years, so two-thirds of that (Wellington's stock weighting) is 6%. Lehman's bond index is up 6% a year, so one-third of that is 2%. Thus, if Wellington was dumb or ordinary, it would have a long-term return of 8%, not its actual 10%. That is an excellent result. At Dodge & Cox, you find a similar pattern. Dodge & Cox Balanced fund (DODBX) has returned 12% over ten years and 10% for five -- better than you would have earned with 60% of a chunk in Dodge & Cox Stock (DODGX) and 40% in Dodge & Cox Income (DODIX). All of these Dodge funds are closed to new investors, but if you're an existing shareholder, don't hesitate for a minute to feed the balanced fund. It works because Dodge & Cox, like Vanguard, is good at both stocks and bonds. Not all fund companies are.

After the two-chances-to-fail argument, balanced-fund naysayers contend that you'll do better if you pair a terrific stock fund with an excellent bond fund. That, however, assumes you're a willing fund picker and don't mind extra volatility or the job of rebalancing. Over the past five and ten years, Fidelity Balanced has done so well that only a stellar combination such as Fidelity Contrafund (FCNTX) and Harbor Bond (HABDX) -- that would be the all-world managers Will Danoff and Bill Gross, respectively -- would beat it, and then only by a little.

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There are some crummy balanced funds from third-rate fund companies. But if you stick with quality, there's nothing wrong with using a balanced fund as the cornerstone of any long-term-oriented total-return portfolio. In fact, it's a wise move.